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The truth is in the cash flow

It’s the Vibe (On Overtrading) – Part 3

Posted by on Apr 28, 2014 in Academic Research, Articles, Budgeting and Forecasting, Working Capital

It’s the Vibe (On Overtrading) – Part 3

In this final instalment on Overtrading I will look at the actions a business owner can take to remedy overtrading.

Have a Plan

Growth doesn’t happen by itself. There is activity that you, the business owner, is planning to follow in order to generate growth.

As such, you have the opportunity to plan at the outset for the resources you need to support your growth ambitions – be it more people, more equipment, more space or more cash.

You need to prepare a budget that identifies the expected financial impacts of your growth plan on your profitability, balance sheet and cash flow.

By having a plan and a budget you have operational and financial reference points against which to track your actual progress. It will quickly become apparent whether you are growing quicker or slower than expected and whether the actual operational and financial impacts are within or outside expectations. This frame of reference will help you decide what changes you need to make to your plan and the required resources to support the revised plan.

If you haven’t planned, and find yourself in an overtrading situation, then these are the steps you need to take:

Self Help First

Firstly, you need to stay on top of your working capital.

This means being disciplined with invoicing and following up with a good collection process.

It means identifying slow-moving stock and considering whether it should be discounted for a quick sale to bring in cash.

It could mean asking creditors for a temporary extension to your payment arrangements.

Essentially, you need to be doing everything possible to increase the amount of cash coming into your business whilst slowing the outflow of cash as much as is commercially feasible. This will buy you time to reorganise the people and equipment resources needed to support your growth.

An Operational Plan Next

Secondly, you need to fix any operational problems.

Do you have all the fixed assets you need to support the level of growth being experienced? Is additional plant and equipment needed? How much will it cost, and how quickly can it be installed and operating?

Do you have road blocks in your processes and procedures that are slowing down your productive capabilities? Ask your employees about this – you might be surprised by their insight.

Do you have the right number of employees to support the new level of business activity? How long will it take to find and train new employees? Is there a need to use a labour hire company to help out on a temporary basis?

Is it possible to sub-contract out some of the work whilst your labour and equipment requirements are brought into line with the new level of business activity?

Is it possible to reschedule delivery time frames whilst these activities are undertaken?

Will the business continue to be profitable once the new resources are deployed?

A Cash Flow Forecast Last

The financial effects of the prior two steps now need to be incorporated into a cash flow forecast. It should be a weekly based forecast for the first three months, moving to a monthly based forecast for the following 9 months.

If the forecast indicates a need for additional finance you are now in a position to approach your financier with a cogent explanation of the issues you are facing, the steps being taken to rectify those issues and the short and medium term financing needs of your business.

If you can show a clear pathway out of your cash flow crisis then you have a chance that the finance needed will be approved, as it is only a temporary requirement.

If you can’t show a pathway out then you face a credibility issue with your financier – the precursor to a collapse caused by overtrading.

The Key Message

The key message for business owners (and their advisers) wanting to avoid the trap of overtrading is to plan for growth upfront, to track performance against plan, adjusting and revising the plan as dictated by the real world experience.

It’s the Vibe (On Overtrading) – Part 2

Posted by on Apr 17, 2014 in Academic Research, Articles, Working Capital

It’s the Vibe (On Overtrading) – Part 2

My first post on this topic dealt with the consequences of overtrading and the difference between business growth and overtrading.

This post will help an owner of a small or medium-sized business identify when their business is overtrading.

I think there are a number of qualitative and quantitative signals that help a business owner identify when growth has become overtrading.

Here’s what I would be looking out for:

Qualitative Factors

  1. A feeling of being overwhelmed by the volume of orders on hand;
  2. Increasing volume of customer complaints, or customer complaints when previously there were none;
  3. Rapidly changing priorities;
  4. Lack of time to concentrate on other (staff training, financial, etc) aspects of the business.

Quantitative Factors

  1. Negative operating cash flow*;
  2. Rapid increase in net working assets#;
  3. Rapid lengthening of the Cash Conversion Cycle#;
  4. Rapid lengthening Debtor Days and Stock Days#;
  5. Extending Creditor Days# beyond agreed payment terms;
  6. Insufficient funds in the bank account to meet normal operating expenses.

* A quick way to measure Operating Cash Flow is to calculate the Net Profit after Tax for the period, less dividends paid in the period, plus depreciation expensed in the period less the increase / plus the decrease in Net Working Assets over the period.

# Follow the link to find out what these terms mean and how to use your financial information to measure and track them over time.

As the business owner generally works in the business I think it most likely that they will notice the qualitative factors first. As a business adviser often sees the business from a financial perspective I think it most likely that they will notice the quantitative factors first.

In isolation, I think of these factors as trip-wires. They alert the business owner to the danger that growth is becoming overtrading. So, whenever one of these wires is tripped, the business owner (or their adviser) should take a hard look at whether other signals are also present. For example, a business owner feeling overwhelmed by the volume of work should take a hard look at what is happening to the working capital of their business. Similarly, a business adviser seeing a trend of negative operating cash flow should ask the business owner about the volume of work, level of complaints, etc.

If only one type of factor is evident (ie: either qualitative or quantitative, but not both) then overtrading may not be an issue. However, I think overtrading is definitely occurring when both qualitative and quantitative factors are evident. 

So, here is the message for business owners (and their advisers): By knowing the difference between growth and overtrading, and the signals that help identify overtrading, a business owner (or their adviser) is in a position to take action to mitigate the damage caused by overtrading.

My next post, which will be the last on this topic, will look at some of the responses a business owner can take to remedy overtrading and return to growth.

It’s the Vibe (On Overtrading)

Posted by on Apr 11, 2014 in Academic Research, Articles

It’s the Vibe (On Overtrading)

Do you remember Dennis, suburban solicitor and defender of the common man from the 1997 movie, “The Castle”?  Hopelessly out of his depth, he represents the Kerrigan family in court, to save their home from compulsory acquisition. In making his closing argument, Denis utters these immortal words “…in summing up, it’s the constitution, it’s Mabo, it’s justice, it’s law, it’s the vibe and uh, that’s it, it’s the vibe”.

I was reminded of that scene the other day, when I found myself musing over the difference between growth and overtrading. The train of thought had popped into my head because I have recently been helping owners of small and medium-size businesses that are undergoing rapid growth. I first heard the term “Overtrading” in 1988-89, just prior to the last prolonged recession in Australia. Whilst the “vibe” of the term was always clear, nobody I was working with at the time, or since, could cogently define overtrading for me.

Now, SME owners generally want to grow their business, but overtrading can quickly become fatal for a small or medium-sized business with only limited access to new capital (ie: new debt or new equity). In a 2011 research paper by Johan Van Der Spuy and Gideon Nieman, both of the University of Pretoria, they cite South African based research from 2007 where overtrading is listed as a cause of bankruptcy in 47% of cases.

With these thoughts in my head, I wondered, when does business growth morph into overtrading? What signs will help the owner of a small or medium-size business know that they are overtrading? And, how can the owner rectify overtrading?

In this article, the first of three, I will offer the SME owner (and their advisers) an answer to the first question. The second will help the SME owner identify when they are overtrading before it becomes fatal, and the third will set out for the SME owner the actions they can take to mitigate the effect of overtrading.

There is very little research on overtrading, other than the paper I mentioned earlier. In it were a couple of comments that I found particularly helpful in establishing a definition for overtrading:

  1. Overtrading…is the rapid growth of a business in which such strain is placed on the business’s capacity and/or resources, that when something (small) goes wrong the entrepreneur cannot deliver and problems grow in frequency.
  2. The…sustainable growth rate of a business, is the rate at which a company can grow without creating a cash flow problem.

The message for an SME owner (and their advisers) is that overtrading is incredibly dangerous to their business. It occurs when growth reaches a pace that overwhelms the physical resources of their business such that the quality of the product(s) or service(s) provided suffer and/or when growth reaches a pace that overwhelms the financial resources of the business creating cash flow problems.

Join me in my next post to find out how to recognise the symptoms of overtrading before it fatally damages your business.

Leadership and SME Culture

Posted by on Mar 15, 2014 in Academic Research, Articles, Leadership

Leadership and SME Culture

In my very first post (It’s Not Rocket Science) I outlined four major issues faced by small and medium business, as discerned by Enterprise Connect. One of them was Business Ecology, which I take to mean the workplace environment / organisational culture.

A recent article I wrote on the usefulness of KPIs (The Emperor’s New Clothes) received a comment from a reader, which put forward the proposition that an organisation’s culture is responsible for whether employees deciding to game or not game their KPIs.

Considering the foregoing, I’ve been mulling over business culture, particularly since the exchange with that reader of my earlier article. What is the nature of an organisation’s culture? How does an owner of a small or medium-sized business created a good business culture? What is the benefit of doing so? What qualities does an owner of a small or medium-sized business need to create the best business culture?

For the purpose of this article, and in the context of SMEs, I am going to define an organisation’s culture as being the relationship between an SME owner and their staff. Later in the article, references to “leader(s)” are interchangeable with “SME owner”.

So, what then of the other questions? I found three particularly insightful articles on The Conversation web-site.

The first, Why autocratic bosses are a dying breed, by Morgan Witzel provides fascinating insights into the nature of business leadership. This is more an opinion piece than research, but the author does back up his opinion with numerous examples of high-profile business leaders. Witzel’s central point is that the best that leaders can hope to do is bring people together and try to persuade them to work together.  He makes a couple of other points for SME owners to consider:

  • Leaders (SME owners) need to learn humility.
  • Leaders (SME owners) need to work in partnership with their organisations (people).
  • Leadership is something best done with people, not to them.

The second, Productivity Push should focus on frontline managers, by Daryll Hull offers insights into the qualities of an excellent workplace leader. It references previous academic studies in this area, and provides the links to those studies. In this article you will find a range of characteristics, sourced from research carried out by the article’s author on behalf of the Business Council of Australia. Some of the characteristics of an excellent workplace leader include: fairness, accessibility, ethical, empowering people, giving recognition where due, building trust and no bullshit.

This article also addresses the primary benefit from creating a good culture through leadership, being improved productivity. And to be clear, productivity in this sense is the amount of output per unit of input. To do this well, the author recommends that the business develop the leadership skills of their supervisors and line managers through training. My own view, in the context of an SME, is that the owner should undertake this sort of training first, and then follow it up with training for their supervisors / managers. This will ensure they have a “common language” when working on the business culture.

The final article, How individual firms can solve the ‘productivity paradox’, by Danny Samson is research orientated and offers an insight into the benefit of creating a good culture. It’s a great article which sets out in stark terms the scale and nature of the problem in terms of labour productivity, and then offers a solution, which is for the business owner to ask the workers on the “floor” to identify the activities that create noise in their day, engage them to find the supporting data, work with them to find a solution and empower them to implement that solution. In my opinion, an SME owner that follows this process will go a long way to creating a great workplace culture.

For my own part, I would add the following practical suggestions on how an SME owner can create a strong culture:

  • Smile.
  • Take an interest in your people.
  • Explain how their activities contribute to the success of the business.
  • Treat people the way you would like to be treated.
  • Listen (hard) to your staff.

In summary, the owner of a small or medium-sized business who treats their employees as people first, explains to them the importance of their role, demonstrates that their efforts are valued, engages with and empowers them will reap the benefits of a highly productive workforce.

KPIs for All SME Businesses

Posted by on Feb 7, 2014 in Articles, Budgeting and Forecasting, Drivers of Cash Flow, Working Capital

KPIs for All SME Businesses

The play, “A Man for All Seasons” tells the story of Sir Thomas More, the C16th Chancellor of England who refused to endorse Henry VIII’s wish to divorce his wife, Catherine of Aragon. More was a man of great integrity, who whilst pragmatically adapting to changing circumstances, remained true to his beliefs despite enormous pressure being brought to bear upon him.

This article will describe a set of KPIs for SMEs that behave in a similar fashion to Sir Thomas More. These KPIs offer the SME owner a succinct and relevant insight into their business under all conditions, irrespective of Industry, external factors or pressures. Being easily identified and measured they are pragmatic. They are the “Universal KPIs” I referred to in The Emperor’s New Clothes (About KPIs).

Those of you who have read some of my earlier articles may have guessed the identity of my Universal KPIs. I introduced them in The Magnificent Seven and built on that introduction with posts on interpreting financial information (Cracking the Code) and understanding working capital (Seeing the Light (On Working Capital)).

The table below sets out my Universal KPIs and depicts a hypothetical business story (click on the table to expand it):

KPI Table

This table shows Monthly and Year to Date outcomes for my Universal KPIs. The stories told by the table are summarised below, which I hope will help the reader appreciate the clarity of the insight provided by these KPIs.

The Monthly Story

Sales are $45k below budget. However, the above budget Gross Margin of 47% has reduced this cash drain to $9.65k. Operating Expenses (which exclude Interest Expense and Depreciation) are $10k lower than forecast. The net outcome is a small inflow of $350, relative to the budget expectations.

Debtor Days have shrunk to 60 from 62 in the prior month, but the average time taken to collect debtors remains slower than the budget expectation (55 days). Nevertheless, the 2 day reduction in debtor days compared to the prior month has brought $30.7k of cash into the business. Stock Days have shrunk to 95 from 97 in the prior month, but the average time taken to sell stock remains slower than the budget expectation (90 days). Nevertheless, the 2 day reduction in stock days, relative to the prior month, has brought $16.7k of cash into the business. Creditor Days have expanded to 40 days from 37 days in the prior month, and Creditors are now being paid 1 day slower than the budget expectation (39 days). In the current month, the 3 day expansion in Creditor Days has resulted in $25k being retained in the business. Shortening the Cash Conversion Cycle by 7 days during the month has brought $72.4k of cash into the business.

Capital Expenditure in the month was $10k, in line with budget.

In summary: The cash brought into the business from its earnings during the month was in line with budget, albeit the manner in which this was achieved was different from expectation. The actual cash used for capital expenditure purposes met budget. The vast majority of the $72.75k of cash brought into the business during the month is due to a shortening of the Cash Conversion Cycle relative to the prior month.

The Year to Date Story

Sales are $400k below budget. However, the above budget Gross Margin of 45.6% has reduced this cash drain to $146.4k. Operating Expenses are $50k below budget, further reducing the cash drain to $96.4k.

Debtor Days are averaging 60 days, slower than the budget expectation of 55 days, leading to a $16.4k outflow of cash from the business. Stock Days are averaging 95 days, slower than the budget expectation of 90 days. Nevertheless, despite the slower stock turnover there has been a $20.8k inflow of cash in the Year to Date, reflecting the lower business activity and higher gross margins. Creditor Days are averaging 40 days, slower than the 39 days forecast, resulting in $18.8k of cash being retained in the business. Although the Cash Conversion Cycle has expanded by 9 days from 106 days per the forecast to 115 days there has been a net cash inflow of $23.2k, due to a shrinkage in Sales and the higher Gross Margin.

Capital Expenditure on a Year to Date basis is $40k, a saving of $10k on the budget, resulting in that amount of cash being retained in the business.

In summary: The net outcome is that the business has $63.3k less cash than forecast. This outcome has mainly been driven by the lower Sales, which an improved Gross Margin, lower Operating Expenses, lower Capital Expenditure and a modest inflow of working capital funds (as a consequence of the shrinking business activity, not due to a shortening of the Cash Conversion Cycle) has not been sufficient to offset.

All of these factors can be influenced by an SME owner. Indeed, if the Cash Conversion Cycle had met the budget expectation the result would have been a $10k cash inflow into the business in the year to date, relative to expectations.

The Message for an SME Owner

 When I worked in banking, these seven factors were the major drivers of our financial forecasting software (there were a few others: depreciation rates, interest rates, tax rates, dividend rates etc).  They are used because of their close link to the “operational” cash flow of an SME business.

This in part explains why they make great KPIs for an SME. The other significant factor in their suitability as KPIs is that the SME owner can make decisions and take actions that impact on each of theses 7 factors, and hence directly impact the cash flow of their business.

I regard them as Universal because all SME businesses, regardless of Industry, are capable of measuring Sales, Gross Margin, Operating Expenses, Debtor Days, Stock Days (or for professional firms, its equivalent, Work In Progress Days), Creditor Days and Capital Expenditure.

So, if you own a small or medium-sized business and would like to know more about its financial and cash flow health then a good place to start is by tracking these 7 factors on a monthly and year to date basis.

The Emperor’s New Clothes (About KPIs)

Posted by on Jan 28, 2014 in Articles, Drivers of Cash Flow

The Emperor’s New Clothes (About KPIs)

I recently read an interesting article on Key Performance Indicators (KPIs) by the economics journalist, Ross Gittens, which prompted me to consider when and how KPIs are best used. I thought I would share my conclusions in this post.

Key Performance Indicators (KPIs) are an established part of the business world, used in many organisations whether operating in the public or the private sector, often to encourage particular employee behaviour and focus, and as an objective means of measuring and ranking performance with consequences for employee remuneration.

They are quantitative or qualitative measures used to review an organisation’s progress against its goals. They may be broken down and set as targets for achievement by departments and individuals. The achievement of these targets is then regularly reviewed.

As such, KPIs immediately meet three of the criteria needed for setting effective goals, in that they are specific, measurable and time bound. Depending on where the benchmark is set, KPIs will also meet the other two criteria for setting effective goals, being that they are also attainable and realistic.

No wonder then that their use in business is extensive.

What about the disadvantages of using KPIs? From the article written by Gittens it is clear that he is not a fan of KPIs. The summary of his misgivings on KPIs is that they can be manipulated. He argues that most jobs are multi-dimensional, and that you cannot construct a KPI covering every dimension – hence the manipulation occurs by cannibalising some dimension of a job (usually quality related) not covered by a KPI. In other words, KPIs are usually capable of only measuring quantity, but not quality.

Hmm, quite the conundrum. On one hand, we have an established business practice that has been widely used for many years. On the other, an argument that says KPIs are simplistic in nature and open to manipulation.

So, are KPIs really useful, or a dangerous fad, a modern-day business-related take on “The Emperor’s New Clothes”?

I think the answer to that question lies in the implicit assumption of the Gittens article, which is that employees are motivated to manipulate imperfect measures of complex real world relationships by the linking of their remuneration to the KPI outcome. But, does this mean KPIs should be abandoned?

What about the SME Owner? Are KPIs useful to them? My conclusion is absolutely Yes, and I think this because:

there is no motivation for the SME Owner to manipulate KPI outcomes, as there is no benefit to them to see the position of their business other than as it actually is; and

after many discussions with SME owners, I know that most use some type of Rule of Thumb measures (at least) to give them a sense of how the business is operating.  

My position is that whilst there may be some flaws to using KPIs at the employee level, they are capable of providing useful and important signals to the SME Owner about the health of their business.

This led me to another train of thought, what are the best KPIs for SME Owners to use? Is there a set of “universal” KPIs that are capable of providing useful and important signals for all SME Owners?

I think there is and in my next post, I will share with you my ideas on a set of universal KPIs for the SME Owner. You will discover that these KPIs are easy to measure; capable of being adapted and used by a wide variety of business; represent activities that directly affect the amount of cash that a business produces; are readily influenced by the decisions and actions of the Business Owner; and help identify potential deterioration in the major cash-flow generating operations of the business.

Seeing the Light (on Working Capital)

Posted by on Jan 21, 2014 in Academic Research, Articles, Drivers of Cash Flow, Working Capital

Seeing the Light (on Working Capital)

When I was in my teens, a favourite movies was the Blues Brothers. It was shown at the (then) decrepit Cremorne Orpheum cinema in Sydney. We’d watch, dance and sing along to this movie with its absurd plot, revelling in its wonderful sound track.

If you are familiar with the movie, you will know that Jake and Elwood are on a mission from god, to raise the money needed to save the orphanage where they grew up. They don’t know how they are going to source the money until Jake “sees the light” and they decide to put the band back together.

This blog will help SME owners “see the light” on why managing working capital is an easy way to increase cash flow. It picks up on a key message from the research set out in my first blog (It’s Not Rocket Science, 19 November 2013) being that a business with a shorter cash conversion cycle (ie: one that manages its working capital) has better liquidity, requires lower levels of capital and enjoys better returns on investment than a firm that does not manage its working capital. It will give the SME owner the tools needed to begin managing working capital.

First, let’s define a few key terms.

The Cash Conversion Cycle is the number of days between the outlay of cash (to acquire inventory, for example) and the recovery of that cash (the collection of sale proceeds from debtors). It is calculated by adding Debtor Days to Inventory Days and then deducting Creditor Days from this figure.

Debtor Days is a measure of the number of days it takes to collect debtors. It is calculated by dividing Trade Debtors at a point in time by the aggregate of Sales for the 12 months to that point in time and multiplying that result by 365.

Inventory Days is a measure of the number of days a business holds its stock before it is sold. It is calculated by dividing Stock at a point in time by the aggregate of Cost of Goods Sold for the 12 months to that point in time and multiplying that result by 365.

Creditor Days is a measure of the number of days it takes a business to pay its trade creditors. It is calculated by dividing Trade Creditors at a point in time by the aggregate of Cost of Goods Sold for the 12 months to that point in time and multiplying that result by 365.

The Capital of a business is the sum of the equity provided by the owners of a business plus the debt a business has raised from its financiers.

The Working Capital of a business is the amount of Capital invested in the Net Working Assets of the business.

The Net Working Assets of a business are its Inventory plus Trade Debtors less Trade Creditors.

To manage Working Capital an SME owner first needs to measure and track the value of the Net Working Assets and Cash Conversion Cycle.

Net Working Assets represent a Point in Time view of Working Capital. An SME owner who tracks the value of their Net Working Assets on a monthly basis will know the amount of Capital invested as Working Capital and whether that investment is rising (using cash) or falling (generating cash). By breaking the Net Working Assets into its constituent parts, the SME owner can establish the driver(s) for the movement in their Working Capital.

The Cash Conversion Cycle is a Relative view of Working Capital, which provides the SME owner with information about how their Net Working Assets are moving relative to the trading of the business. By tracking the Cash Conversion Cycle over time a business owner will receive information about how efficiently their business is using its available Capital – a falling Cash Conversion Cycle is a sign that capital use is becoming more efficient (ie: you’re stretching a dollar of capital further), a rising Cash Conversion Cycle is a sign that capital use is becoming less efficient (ie: you’re likely to run out of capital sooner).

This information is useful to all SME owners, in all business situations. It is essential for an SME owner with a growing business as nothing uses Capital quicker than growth.

Working Capital management begins when an SME owner uses the information from tracking Net Working Assets and Cash Conversion Cycle to identify and prioritise for review those operational elements of their business that impact on Net Working Assets. For example, the invoicing process, customer credit policy, and debtor collection process have an impact on the value of Debtors and on the Debtor Days ratio – by reviewing these processes it may be possible to reduce the value of debtors / speed up their collection without compromising Sales. Similarly, stock re-order triggers, minimum and maximum holdings, identifying fast and slow-moving stock, and supplier delivery times have an impact on the value of Stock and the Stock Days ratio – by reviewing these processes it may be possible to reduce the investment in stock / reduce its holding period without compromising Sales.

Process improvement can be measured by tracking subsequent changes to Net Working Assets and Cash Conversion Cycle. Using this approach, continuous improvement and low risk, incremental changes to working capital related process is possible. If done successfully, the SME owner will see a permanent reduction in the use of their Overdraft, or a permanent increase of funds in their Bank account.

The SME owner who has “seen the light” has options in the form of access to greater cash flow: they can use this cash flow to invest in the continued growth of their business, to pay a dividend, or increase the efficiency of their business. If you’re not already actively managing your working capital it is time to jump on the band wagon.

Cracking the Code

Posted by on Dec 18, 2013 in Articles, Drivers of Cash Flow

Cracking the Code

If you read my last post, you will now know the seven drivers of business cash flow (The Magnificent Seven).  In this post we will engage in a little code cracking, to help the SME owner make use of the Magnificent Seven.

What makes the Magnificent Seven so magnificent? In simple terms, they represent the operational areas of a business that an SME owner can directly influence through action they consciously decide to take. In other words, they are the levers that the SME owner can pull or release to help achieve a desired cash flow outcome.

But, before levers get pulled or released, you need to first spend some time tracking the movement of the Magnificent Seven.  It is then necessary to know how to interpret what that movement is telling you. So, let’s establish the rules for decoding the information embedded in The Magnificent Seven. There are six of them and they are:

An action or activity that increases your Earnings is a Source of Cash. 

This means an increase in Sales or Gross Margin, or a decrease in Total Operating Expenses are Sources of Cash.

An action or activity that decreases your Earnings is a Use of Cash.

This means that a decrease in Sales or Gross Margin, or an increase in Total Operating Expenses are Uses of Cash.

An action or activity that increases your Assets is a Use of Cash.

This means that an increase in Debtors, Stock or Net Fixed Assets is a Use of Cash.

An action or activity that reduces your Liabilities is a Use of Cash.

This means that a decrease in Trade Creditors is a Use of Cash.

An action or activity that reduces your Assets is a Source of Cash.

This means that a decrease in Debtors, Stock or Net Fixed Assets is a Source of Cash.

An action or activity that increases your liabilities is a Source of Cash.

This means that an increase in Trade Creditors is a Source of Cash.

It is easy to track this information. Start by extracting the value for each of the Magnificent Seven from your accounting system each month and recording them on a separate spreadsheet, piece of paper etc. There are a couple of tricks to bear in mind when extracting this information:

Firstly, you need to multiply the Sales for each month by the Gross Margin applicable to that month to get the Gross Profit for that month. Make sure you record this figure as well.

Secondly, when extracting the figure for fixed assets make sure it is net of the accumulated depreciation charged against those assets.

Now, having extracted the information it is time to start using it. Here is what you do:

To determine the movement in the Magnificent Seven, subtract last month’s values for Sales, Gross Profit (remember Gross Profit is Sales multiplied by Gross Margin), Total Operating Expenses, Debtors, Stock, Creditors and Net Fixed Assets from this month’s values for the same items.

Reverse the sign of the number you have derived for the movement in Total Operating Expenses, Debtors, Stock and Net Fixed Assets.  So, if the movement in Total Operating Expenses is prima facie a positive number, reverse the sign so that it becomes a negative number; if the movement in Debtors is prima facie a negative number, reverse the sign so that it becomes a positive number etc.

Recheck the now adjusted numbers you have derived for the movement for each of the Magnificent Seven using the six rules set out above.  Positive numbers should represent Sources of Cash and Negative numbers should correspond to Uses of Cash.

Now, add the movement for Gross Profit, Total Operating Expenses, Debtors, Stock, Creditors and Fixed Assets. If the answer is a positive number then that tells you that operationally, the business has generated cash in the month.  If the answer is a negative number then that tells you that operationally, the business has used cash in the month.

You now have a simple method to identify how your business operationally produces and uses cash. This information will alert the SME owner to where lazy cash is being hidden in the business. It is also information that the SME owner can use in a myriad of ways, including identifying and prioritising operational areas for investigation and potential process improvement.

The Magnificent Seven

Posted by on Dec 6, 2013 in Articles, Drivers of Cash Flow

The Magnificent Seven

No, this post is not about the epic western, starring Yul Brynner, in which oppressed Mexican villagers hire seven gun-slingers to save them from an evil bandit and his gang. Rather, it is about helping the SME owner understand the Seven Drivers of Cash Flow, knowledge which will help protect your business in good and bad times.

This post marks the commencement of our journey to find answers to the issues identified in my previous blogs (It’s not Rocket Science and Budgeting: A Means to an End).

Let’s begin with a quick recap of the key messages from my previous posts:

To understand your cash flow you need to use all your financial information. You need to pay attention to both your Profit and Loss statement and Balance Sheet.

The objective of preparing a budget is not to predict the future with accuracy. Rather, a budget is a tool that should be regularly reviewed and updated for real world impacts. It is a means to an end, not an end in itself.

 The drivers of cash flow I am about to introduce will help the SME owner address these messages as:

They are found in both the profit and loss statement and the balance sheet, and hence help you use all of your financial information whilst not drowning you in detail; and

Continual monitoring of these drivers will reveal their inter-relatedness. Understanding these links simplifies the budgeting process, and focuses you on the key pieces of financial information that you should regularly review.

So, which pieces of financial information make up The Magnificent Seven?  They are:

Sales: The foundation of your cash flow. As sales change there is usually a corresponding change in debtors, stock, creditors and total operating expenses.

Gross Margin: The Gross Profit of a business (Sales less Cost of Goods Sold) expressed as a percentage of Sales. The higher the Gross Margin, the greater the value added to the business per dollar of sales. For a service business (ie: one that provides a service as opposed to selling goods) the Gross Profit is equivalent to Sales less the direct costs of providing those services (ie: the salaries and commissions you pay your sales staff).

Total Operating Expenses: The costs incurred to run your business.  The gross profit needs to be sufficient to cover your Total Operating Expenses if you are to make a profit. Generally, the higher your gross margin the more quickly your Total Operating Expenses will be covered.

These three drivers are all found in your Profit and Loss Statement.

Debtors: Represent the money owed to you by customers to whom you have made sales with credit terms attached. As your sales change, so too should your debtors.

Stock: Represent goods on hand ready for sale, or to be converted through a manufacturing process into goods for sale. For a service business the equivalent to stock is Work in Progress. Many businesses must buy or manufacture stock before selling it. As sales change, so too does the required investment in stock.

Creditors: Represent the money you owe the suppliers of the goods and services used by your business. As sales change, so too should your creditors.

Capital Expenditure: The money a business spends on plant, equipment, motor vehicles, furniture, fittings etc. As the business grows (ie: as sales increase) then the required investment in this equipment also increases.

These four drivers are all found in your Balance Sheet.

Now, here is the pay-off.  By paying attention to these seven pieces of financial information and tracking them over time you will uncover valuable information about how your business is operating.

Consider this example. If your debtors are increasing at a rate faster than the rate at which your sales are increasing, and if you haven’t changed the terms on which you offer credit, then that is an indicator that there has been an operational deterioration in your debtor collection process. The vigilant owner, understanding the relationship between their sales and debtor levels, uses changes in that relationship as a trigger to find out what is happening before a serious cash flow problem arises.

I will have more to say on how the Magnificent Seven can be linked to operational aspects of a business in a later post.

For now, the key message to SME owners is that The Magnificent Seven is not a movie, but the vital pieces of financial information that will help you understand the cash flow of your business and alert you to changes in its operational health.

Budgeting: A Means to an End

Posted by on Nov 28, 2013 in Articles, Budgeting and Forecasting

Budgeting: A Means to an End

In my last post, I made the point that for a business to properly understand its cash flow it needs to pay attention to both its Profit and Loss statement and its Balance Sheet. It follows then, that when preparing a budget, a business needs to complete one that covers both its Profit and Loss statement and its Balance Sheet.

However, my experience has been that: i) the majority of those businesses which prepare a budget, only do so for their Profit and Loss Statement, and ii) there is a high level of resistance to preparing a budget amongst SME owners (and this experience is confirmed by the research, again see my last post).

Why is this so? My hypothesis is that: i) SME owners (and their advisers) may not have the necessary skills to produce a budget balance sheet, and ii) SME owners resist preparing a budget because of the inherent uncertainty involved in such activity.

Is there a solution to these issues?  I think so.

I’d like to first deal with the inherent uncertainty in preparing a budget. I’ll start by referring you to this column by Ross Gittens, an economist who writes for Fairfax. I have been reading him since 1983 and have found that he writes with simplicity and clarity about a subject that is not the most approachable.

This particular column deals with, amongst other things, the accuracy of the Reserve Bank of Australia’s forecasts for Inflation and GDP.  It summarises the results of a review by the RBA of its forecasting accuracy, based on the range of the actual forecast errors it made between 1993 and 2011. The column is an easy read, but for the time poor, the relevant and practical messages from it are:

The accuracy of the RBA’s forecasts is not particularly high.

Their experience is typical of that of similar bodies around the world. For example, The Treasury Department of the Australian Federal Government completed a review in November 2013 of its forecasting accuracy, and arrived at a conclusion that is consistent with the RBA. If you are mathematically minded you will find the Treasury paper interesting.  However, for most people, the key take-away will be in Treasury’s conclusion, that “rather than focussing on precise point estimates, a more nuanced discussion would acknowledge that uncertainty is an unavoidable feature of forecasts…”

Gittens makes the point that the RBA’s lack of accuracy is not a major issue because: i) the RBA revises its forecasts every quarter based on the actual GDP and Inflation results as they come to hand, and ii) the RBA usually adjusts its cash rate in an incremental fashion, thereby limiting the impact of getting it wrong.

Lastly, Gittens points out that the RBA is not afraid to change direction if it becomes obvious that it should do so.

So, what lessons can SME owners (and their advisers) draw from the experience of organisations that are arguably the best in the forecasting business? I think they are:

  1. Budgets are best used as a tool, constantly reviewed and adjusted for real world impacts, and  
  2. A budget is a means to an end, but not an end in itself.

I’d also add that a further practical benefit of the budgeting process is it requires the SME owner to identify the specific steps they need to take in order to achieve their budget’s outcomes.  This provides the SME owner with a context from which to make informed decisions when the real world intersects with their budget. It enables the SME owner to review whether they have taken all the steps they identified or whether some other factor has changed (currency, economy, competition etc). This context means the SME owner makes an informed choice when deciding whether and what action to take in light of actual results to date.

Addressing the skill issue is relatively easy. There are many avenues of help available to the SME owner.  The first port of call is their accountant.  Other possibilities include their business banker, or finance broker (if the business uses one). Certainly, the business banker has access to off the shelf software that can be used for forecasting both balance sheet and profit and loss statement. The better finance brokers will use similar software, but it may be necessary to pay them a fee. Finally, there are specialist businesses, like my own, with the capacity to help.

Put simply, help is available and there is little excuse for a determined SME owner not being able to find it.